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Price, Costs, and Profit
Economic Underpinnings of Pricing
This chapter shows how price affects profit and describes major price determinants. In principle and in theory the economic underpinnings of price are simple, but in practice they are more subtle, due to the multiple effects of price on profit.
It is obvious that price directly affects the unit profit margin. A higher price yields a higher margin per unit sold, and thus a higher profit for a given sales volume. However, a higher price typically implies a lower sales volume, thus producing an offsetting impact on profit. Price may also impact cost: e.g., a higher sales volume resulting from a lower price may induce a decrease in unit costs due to economies of scale or learning. Or a lower price may attract new buyers who remain loyal in the future, and thus increase future profits. These issues will be addressed in subsequent chapters. Here we focus on the more direct and current influences of price on profit.
Figure 2-1 shows the profit system in a simple hierarchical form. Scanning downward, at the first level profit drivers are sales revenue and costs. The sales revenue is, in turn, price times sales volume. Costs have variable and fixed components. Variable costs change with the sales volume but fixed costs do not. The cost of an additional unit is referred to as marginal cost.
WHAT THIS CHAPTER WILL DO
This chapter addresses the following questions:
1. How do price changes affect profit?
2. How do customers respond to price changes?
3. Which factors affect the price decision and how?
4. How can conflicting objectives like profit and volume be reconciled when making pricing decisions?
5. What is the role of variable and fixed costs in pricing?
Knowing the answers to these questions will help the manager to:
1. fully understand and correctly judge the effects of price
2. consider the right factors in making price decisions
3. base price decisions on the customers' perceived value rather than on cost
4. deal with practical conflicts in pricing
THE IMPACT OF PRICE CHANGES
To illustrate the profit impact of a specific price and possible changes in that price we consider the case of a product we call POWERSTAR, an electric power tool. The manufacturer sells the product directly to professional customer's at a price of $100. The worldwide annual sales volume is around 1 million units. The variable unit cost or marginal cost of the product is $60, so that the unit contribution the difference between price and variable unit cost is $40. Thus, each unit sold contributes $40 to the recovery of fixed costs and to profit.
The upper part of Figure 2-2 illustrates this situation, in which the company achieves a sales revenue of $100 million ($100 times 1 million units). The shaded rectangle represents the total contribution of $40 million, which results from 1 million units each of which contributes $40. The total contribution can always be represented as a rectangle since it is obtained as the product of unit contribution and sales volume.
The fixed costs such as plant and administration for POWERSTAR are estimated at $30 million; subtracting this from the total contribution of $40 million yields a profit of $10 million or 10% of the sales revenue. Alternatively, the profit can be calculated by taking the total costs of $90 million ($60 million variable costs plus $30 million fixed costs) and subtracting them from the sales revenue of $100 million. Total costs per unit are $90 and the unit profit margin (to be distinguished from the unit contribution) is $10. The return on sales of 10% is a relatively typical magnitude for industrial products of this kind.
POWERSTAR management questioned whether the current $100 price yielded the highest possible profit and suggested considering alternative prices in the range of plus or minus 20% from the current price. As a first step, management wanted to know the sales volume required to maintain the $10 million profit with alternative prices.
We first consider a 20% price cut alternative. An $80 price and unchanged variable unit costs of $60 reduce the unit contribution from $40 to $20. Thus, POWERSTAR now has to sell twice as many units as at a price of $100 to achieve the same total contribution and profit. With 2 million units sold at $80, sales revenue would increase to $160 million. We show the $80 price scenario in the middle of Figure 2-2. Since the profit contribution is unchanged, the surface of the shaded rectangle is the same as in the upper part of Figure 2-2. While the price reduction is only 20%, the reduction in unit contribution is 50%. The sales increase required to compensate for this smaller margin accordingly is 100%. Such a 100% increase in sales volume due to a 20% price change was seen as unrealistic to management. In addition capacity was insufficient to manufacture the higher volume. A capacity expansion would have induced higher fixed costs.
The 20% price-increase scenario is summarized at the bottom of Figure 2-2. Unit contribution increases to $60, thereby requiring only 667,000 units to be sold to generate $10 million profit, a 33.3% decrease in volume. If sales decline by less than 33.3%, the price increase would drive profit up. For example, if 750,000 units were sold at $120, profit would increase from $10 million to $15 million. Thus POWERSTAR management judged the price-increase scenario worthy of more investigation.
As we see, price decreases and increases have highly leveraged effects. A seemingly small price reduction can have a large negative impact on unit contribution, requiring a tremendous increase in sales volume to generate the same profit. A small-percentage price increase can have a strong positive effect on unit contribution, creating a large acceptable decrease in sales volume while still retaining the profit level.
The POWERSTAR case is somewhat typical for industrial products where variable costs often amount to 50% or more of price and are high relative to fixed costs. Such service industries as hotels, airlines, and telecommunications, in contrast, typically have relatively low variable but high fixed costs. Similar cost structures characterize industries such as software and pharmaceuticals, where R&D accounts for the bulk of costs and unit variable costs tend to be very low.
Cost structure has a strong impact on the price-profit relationship. For example consider SUPRACOM, a new entrant in the telecom market in a European country. It runs its own network in its domestic market but has to buy capacity from third parties for its international services. Its variable cost for domestic traffic is 5 cents per minute; for international traffic, SUPRACOM has to pay 40 cents per minute to its foreign suppliers.
SUPRACOM's price per minute is 40 cents for domestic and 60 cents for international traffic, yielding per-minute contributions of 35 cents for domestic and 20 cents for international service. To cope with increasing competitive pressures the company was considering price cuts of 10 cents a minute for both services. What increases in sales volume would be required in each service to leave its profit unchanged? Per the analysis above, the required sales volume increases for international and domestic service are 100% and 40% respectively.
The 10-cent price cut requires a much stronger sales increase for international service because the international-unit contribution is cut to half while the domestic-unit contribution declines only by 28.5%. In general, a much greater increase in sales volume is required to offset the negative effect of a price cut if variable costs are high.
In judging price decrease advisability, one must consider available capacity. In 1994 Lufthansa offered flights on domestic routes at DM 99 ($66). In spite of severe availability restrictions, demand exploded; allotted capacities were sold out for up to five months. In light of the limited available capacity, the new price was too low and profit opportunities were lost. We suspect that this often happens in the airline and similar service businesses when prices are cut by 50% or more. The volume increase required to compensate for the reduction in unit contribution may well exceed the available capacities.
Figure 2-3 puts the considerations on price and sales volume changes into a more general perspective. The horizontal axis depicts variable unit cost as a percentage of current price. The vertical axis shows the required increase in sales volume (upward) and the acceptable decrease in sales volume (downward) to return the same profit. We consider price increases and decreases of 10% and of 20%.
We first consider the price-decrease curves, seen in the upper part of the figure. The 20% price-cut curve shows that, with a variable unit cost of 60%, such a cut requires a 100% increase in sales volume (point A). This corresponds to the POWERSTAR case. If the price cut is only 10% the required sales increase shrinks to 33% (point B). This comparison reveals how strongly profit will react to price changes if variable unit cost is relatively high. The curves get steeper the higher the variable unit cost is. For variable unit cost of 80% of current price, a volume increase of 100% is required to offset a price reduction of only 10% (point C).
In contrast, the 10% and 20% price-increase curves, seen in the lower part of Figure 2-3, are much flatter and closer together. This shows that the acceptable decreases in sales volume react less sensitively to variations in variable unit cost and price.
Figure 2-3, which can easily be expanded to include price changes of other magnitudes, can be used as a simple decision-support tool for considering price changes. While it says nothing about customers' "reactions" to price changes it identifies what those changes must be to maintain profit. In our experience, exhibits of this type can have a strong impact on managers, particularly those considering a price cut. The curves make the implications of a price change transparent and point to volume effects which may not be likely to materialize in reality.
Break-even analysis is another simple way to look at the interaction of price, costs, and profit. Break-even analysis determines for a given price the sales volume at which profit becomes zero or, in other words, where total contribution equals fixed costs. It shows how sensitively the break-even volume reacts to price changes. However, because it only tells the manager which combination of price and volume is required to break even and does not address which high price yields the highest profit, its utility is limited.
COMPARISON OF PROFIT DRIVERS
Price drives profit like no other factor. As discussed at the beginning of chapter 1, improved price realization has a high leverage effect on profit. Following an idea suggested by Marn and Rosiello, Figure 2-4 shows for the POWERSTAR case how a 10% improvement in each of the profit drivers of Figure 2-1 impacts profit. All other factors are assumed to remain constant. A 10% price improvement with no change in any other value yields a 100% profit improvement. This is by far the strongest effect on profit.
Marn and Rosiello: hold that "improvements in price typically have three to four times the effect on profitability as proportionate increases in volume." We have frequently observed such effects.
These data show that efforts are often better allocated to increasing or defending price levels than to increasing sales volume. This is particularly true if unit margins are thin. With thin margins, higher sales volume does not eftectively drive profit up. In such a situation efforts should be predominantly directed at improving the margins. This can be achieved through cost reductions and/or price increases.
A price increase typically does depress sales volume some what but this does not always happen. For example, a leading agrochemical company had adjusted its prices downward to competitive levels. Later, unhappy with the resulting thin margins, the firm gave consideration to possible price increases; this led to a thorough value analysis, which showed that farmers valued the firm's insecticide at 20% more than competitive levels. The analysis proved correct as a 20% price increase was implemented with no sales volume decline yielding a fivefold profit increase! In another case an office-products company eliminated some of its discounts, effectively increasing its prices by 5%. The profit level doubled, as the sales volume change was minimal.
PRICE AND THE CUSTOMER
Price is the economic sacrifice a customer makes to acquire a product or a service. The customer always compares this sacrifice with his perception of the product's value. Price and value are the cornerstones of every economic transaction.
In essence, a customer buys a product or service only if its perceived value measured in money terms is greater than the price. If selecting from several alternatives, the customer prefers the one offering the highest net value, i.e., the greatest differential of perceived value over price. These simple considerations of price and value help us to understand how the customer reacts to a specific price and to price changes.
Figure 2-5 illustrates the situation for an individual consumer. We assume his perceived value and his willingness to pay for one can of a soft drink is $1, shown as his "maximum price."
If the price is less than $1, the sales volume to this consumer is 1; if the price is higher than $1, the sales volume is 0. All pricing situations essentially reduce to this simple model the "atomic building stone" of pricing. It can incorporate various situations. For a second can of the soft drink, the maximum price at the same time will probably be lower than $1. The maximum price may vary over time or across individuals. Such variations lead us to the issues of dynamic pricing, market segmentation, and price customization. They suggest that different prices should be asked at different times or from individual customers who differ in their maximum prices.
It is useful to distinguish two situations: "yes:no" and "variable quantity." In the "yes:no" situation, depending on the price the customer buys one unit of the good or none at all. "Yes:no" describes situations like the purchase of a video cassette recorder, a personal computer, a mobile phone, or a car. If the consumer has one unit, he does not need another. In contrast, in the "variable quantity" case depending on the price, the customer may buy one or several units. This describes purchases of goods like minutes of use of a mobile phone, variety-driven items like ties, and consumables like soft drinks. Usually, successive units of a good have decreasing incremental value for a customer.
A firm considering pricing should understand the behavior that best describes its customers. But there is an important similarity in the two situations when the finn considers the overall response to a price in that customers typically differ from one to another in their willingness to pay. This leads us to an overall market response curve relating price to quantity sold, which shows a negative slope the higher the price quoted to the market, the smaller the total sales volume. We call this relationship the price response curve. The price response curve for POWERSTAR, an electric power tool, is shown in Figure 2-6. The methods to actually determine this curve are the subject of chapter 3. In the case of POWERSTAR the curve was determined by a market study which revealed that a price increase of 10% would lead to a sales volume reduction of about 20%. The relationship was essentially linear. For example, at a price of $80, 1.4 million units would be sold, about 40% more than the current volume.
THE OPTIMAL PRICE
Once we know the price response curve, as shown in Figure 2-6, it is straightforward to determine the optimal price. For POWERSTAR with its variable cost of $60 per unit, the feasible price range lies between $60 and $150. As price approaches $60, sales volume increases towards 1.8 million units but unit contribution shrinks toward zero.
As price approaches $150, the unit contribution becomes very large but sales volume declines towards zero. Where then is the optimal tradeoff between volume and contribution? As we know from Figure 2-2, total contribution can always be shown as a rectangle with price on one axis and volume on the other. Total contribution is the product of sales volume and unit contribution. Pictorially, then, our task is to maximize this rectangle within the boundaries of the price response curve; i.e., we want to find the largest rectangle that can be fitted into the triangle ABC in Figure 2-7. This largest possible rectangle is obtained at a price of $105. At this price the sales volume is 0.9 million units and the total contribution is $40.5 million. Deducting from this amount the fixed costs of $30 million we get a profit of $10.5 million, which is 5% higher than the profit at POWERSTAR's current price of $100.
Figure 2-7's profit curve reports the size of the rectangle, i.e., the profit for each price leading to a positive profit in tens of millions of dollars. The profit curve shows the following.
• There is always a price that maximizes profit.
• The more one deviates from the optimal price, the steeper the downward slope of the profit curve becomes. The practical implication of this is that, if we are already off the mark, a further price move in the wrong direction is devastating. But this happens! We see companies already pricing too high pushing that price even higher, like the Western world's automakers in the 1980s, or those whose prices are already too low slashing prices even further, like a typical airline in a price war.
• A price which is too high (e.g., $120 for POWERSTAR) is as bad as a price which is too low (e.g., a price of $90). Often managers delude themselves by thinking that if you are wrong, it does not hurt too much as long as you are wrong on the high side. This is a misperception.
Note that fixed costs have not played a role in our discussion of the optimal price. Figure 2-7 makes clear why this is the case. Fixed costs are simply deducted from the total contribution. If we drew them into the figure they would represent a horizontal line at $30 million; they would be equal for all prices considered, and therefore have no influence on the optimal price. Fixed costs at $20 million instead of $30 million would not influence the shape of the profit curve and the optimal price would remain the same; however, the level of profit would shift upward by $10 million.
The same can be said of any sunk costs, such as for R&D expenditures or market introduction. They should not influence the optimal price.
Figure 2-7 helps introduce the concept of price elasticity, an extremely useful measure of the impact of price changes on sales volume. As we just saw, the response of sales volume to price is a major determinant of the optimal price. Price elasticity is defined as the ratio of the percentage change in sales volume to the percentage change in price, i.e.,
Price Elasticity = % Change in Sales Volume ÷ % Change in Price
In the POWERSTAR case depicted in Figure 2-7, at the current price of $100 a price increase of 10% causes a sales volume decrease of 20%. Hence, the price elasticity in this case is -2(-20%/10%). The relative volume change is twice as large as the relative price change. Formally, according to the definition, price elasticity has a negative sign, because volume change and price change go in opposite directions. However, in business discussions, the opposite movement of price and quantity is well understood and managers may simply talk of the absolute value of the price elasticity. The values of the price elasticity vary. strongly across products, competitive situations, and individual customers; we provide more information on this in chapter 3. The price elasticity is also different at different points on the price response curve.
In practice, if a price elasticity less than 1 is found, a price increase can immediately be recommended, since this means that the percentage of decrease in sales volume is smaller than the percentage of increase in price. For instance, if a price increase of 10% reduces sales volume by only 5% (price elasticity = 0.5), implementing the 10% increase will boost sales revenue by 5% and profit will increase even more. The reverse is true for price reductions; they never pay if price elasticity is less than 1, as in the following case: "After Miller cut its price 20%, Miller High Life sales jumped 9%. Despite the unit sales increase, sales revenue would be 12.8% lower after the price cut, since.80 (price) x 109 (volume) = 87.2, which is 12.8% less than 100.
A SPECIAL CASE: OPTIMIZATION WITH PRICE THRESHOLDS
In the preceding analysis, we have explicitly considered the price response curve with a smooth trade-off between price and volume. In practice we sometimes encounter a pricing requirement for a "yes:no" situation for an individual customer. If the price is lower than this customer's maximum willingness to pay or what we call his maximum price, he will buy one unit of the product. If the price is higher, he will not buy. The price response curve, as shown in Figure 2-5, consists of two horizontal sections. Obviously the price that yields the highest profit where the marginal cost is lower than the customer's maximum price is exactly the maximum price. Any price below this figure would mean a profit sacrifice.
If customers were all the same with regard to their maximum prices, we could apply this thinking to the whole market. The aggregate price response curve then has the same structure as the individual response curve. In this case, price response is measured by one single parameter, the maximum price, instead of a whole curve. As long as cost is below this maximum price, that is exactly the price we would like to charge. Figure 2-8 illustrates this situation.
For some products the assumption of homogeneous maximum prices may not be too far off the mark. Lingua Video, a company which sells foreign-language videos, sets its prices along these lines. Its managing director explains, "We assume that our customers have maximum prices which they are willing to pay. We estimate that these prices are typically defined by round figures like DM 50, DM 60, or DM 100 depending on the perceived value of the film. To be on the safe side, we typically set our prices just below these round figures." In Lingua Video's catalogue almost all prices end with a 9: DM 49, DM 59, or DM 99.
Maximum price-oriented price setting offers an explanation for the prevalence of "odd prices" that are just below a round figure. If the assumption on homogeneity of maximum prices is close enough to reality it is a simple and reasonable method for setting prices. One should, however, make sure that this critical assumption holds; this can be done only through understanding each individual's price thresholds.
PROFIT, VOLUME, OR BOTH?
To this point, we have generally assumed that the firm was trying to maximize profit. Indeed, empirical studies have shown this to be the most common goal. But there are also theories that suggest other goals, such as sales maximization, and Japanese companies are said to often strive for market-share rather than direct-profit goals.
In fact complex and often unclear systems of goals are not unusual. A prevalent conflict is between profit and volume goals. Most practitioners love to have higher prices but they hate to lose volume or market share. For example, we once advised a pharmaceutical company to increase its prices and accept market share loss in a small European country where it had low prices. Increasing prices would prevent unwanted shipment from the low-cost country (parallel imports) into the large German market, where its prices were higher. While accepting that this would lead to higher company profits, the management was very reluctant to give up the market-share points in the smaller market.
Many firms have explicit volume or market-share goals. In the auto industry, for example, marketing plans usually prescribe a certain number of cars to be sold. In the computer industry plant capacity is set according to volume goals, and capacity utilization thresholds exist. In service industries occupancy rates are a critical indicator of success. Given these industry and company norms, profit is hardly ever the only goal being pursued in pricing decisions. A mixture of profit and volume goals is more typical for business practice.
Managers usually don't like to trade off volume and profit. They want both an increase in profit and an increase in volume. But what Hudson writes on Escom, then No. 3 in the European PC market, applies to most companies: "Escom has proven a basic business law: You can increase market share or you can increase profit, but it's tough to do both at the same time." It is. however, not impossible!
Juergen Walker, Senior Vice Presiden, Business Management and Controlling, at Mercedes-Benz Passenger Cars, suggested to us a diagram to capture this situation. The diagram, as shown in Figure 2-9, has profit growth on the vertical axis and volume growth on the horizontal axis. The intersection of the two coordinates describes the status quo. The upper fight quadrant (Quadrant I) denotes the "manager's dream" where both profit and volume increase. In Quadrant II profit increases but volume decreases, and the reverse is true for Quadrant IV; a tradeoff between profit and volume growth has to be made in these two quadrants. Quadrant III, the "manager's nightmare," can be avoided. However, few managers seem to appreciate how difficult it is to move into Quadrant I from the origin. Simultaneous pursuit of volume and profit growth may be a good guide for product development. But for price actions it can be unrealistic and frustrating. Figure 2-10, the "Pricing Goal Matrix." is helpful in setting realistic pricing goals.
Figure 2-10 now relates these quadrants to specific price situations. The curves in the four quadrants show the situation underlying the growth and profit possibilities. Quadrant I can indeed happen only if one undertakes a price cut and the current price is higher than the optimal price. That is, to fall into Quadrant I, a particular kind of mistake must have been made in the past.
Eurodisney, the theme park near Paris, fits this description. In the early 1990s the park started with high prices, which were not well accepted by European consumers. The number of visitors and hotel occupancy remained low for the first three years and very high losses were incurred, bringing the company to the verge of bankruptcy. The Wall Street Journal Europe commented that Eurodisney "didn't get the pricing structure right" and that "prices were often criticized as being too high." In early 1994 prices were reduced by about 30% and, according to the article, Eurodisney "now does represent good value for money." The price repositioning indeed worked; attendance at the park increased strongly, and in late 1995 Eurodisney announced that it had become profitable. Another example is Fielmann, the German market leader in eyeglasses and No. 2 in the world, whose price cutting boosted its market share to over 30% in Germany and increased its profitability at the same time.
Quadrant I is also the domain of Intel and its chief executive officer, Andrew Grove. Fortune magazine described their strategy in 1994: "Pushing down prices faster is also part of Grove's master plan. He argues that what Intel gives up in profit margins it can more than make up in volume."
However, Quadrants II and IV are more typical in practice; i.e., either profit increases or volume increases, but not both. In Quadrant II the current price is below the optimum. Thus an increase of the price brings profit up, but volume down. A maker of industrial paint experienced this situation when they initiated a price increase. Some customers who were only willing to buy at very low prices switched to other suppliers. Volume went down by about 20% but profit went up. A loss of $8 million in revenues entailed a profit improvement of $14 million due to better unit contribution margins. Many managers, however, have serious difficulties with this situation because it suggests a weakening of their market position. They are fixated on volume or market-share goals and neglect the profit implications. But sometimes it is reasonable to raise prices and sacrifice volume in order to increase profit.
In Quadrant IV we encounter the opposite situation. If a price which is at or below the optimum is reduced, sales volume increases but profits decline. This situation is typical when market share is to be built or defended. A typical case is the price cut of Philip Morris for its Marlboro brand in the American market in April 1993. (This situation is discussed in detail in chapter 4.) After Marlboro had experienced a major decline in market share due to an increasing price premium over private label cigarettes and resulting share losses to them, Philip Morris cut the price per pack from $2.25 to $1.85, causing a same-day stock-market value decline of $13 billion. But in the aftermath Marlboro's share recovered and the brand again strengthened its leadership position.
A similar move occurred a decade earlier in the German cigarette market. In January 1983, Reemtsma Cigarettenfabriken cut the price of its West brand from DM 3.80 to DM 3.30, the first such move for a branded product in the West German cigarette market since World War II. Within four months West's market share rocketed from 0.6% to 10%, corresponding to an annual sales revenue increase from DM 150 million to DM 2.2 billion.
As can be seen from the profit curve in Quadrant IV, the situation can become quite dangerous if the price reductions lead to further and further deviations from the optimum. Due to shrinking unit contributions, the downward slope of the profit curve steepens rapidly with increasing distance from the optimum.
Quadrant III is the "nightmare situation" where both profit and volume shrink because a price that is already too high is further increased. This has happened to quite a few German machinery companies. Their prices were already too high and not competitive. When several currencies such as the U.S. dollar and the Italian lira were devaluated in 1993, the German products became even more expensive to customers who operate in these currencies. Sales volumes of the machines declined, sometimes by as much as 50%, and several of the companies went into bankruptcy. Again it should be observed that the downward slope of the profit curve can become very steep if prices are much too high.
Figure 2-10, the Pricing Goal Matrix, has proved to be a valuable tool for the analysis of a finn's pricing situation in relation to its profit and volume goals. To make the right price move, we must know where the price currently stands and how sales respond to price changes. Depending on whether the current price is above, close to, or below the optimum, different actions are indicated. It may be that both a profit and a volume increase are possible. But usually the two goals are in conflict and pursuit of growth in both through